We are pleased to report that during 2016 our Equity accounts returned 9.9% for the year compared to a positive 12.0% return for the S&P 500, and our Balanced accounts returned 11.0% compared to a positive 7.5% return for the benchmark (which is weighted 50% S&P 500 and 50% Barclays Aggregate Bond Index).
Equity Review
Our underlying equity positions generated positive returns of 14.1% during the year (excluding cash balances). This was driven by strong gains in our remaining energy and commodity related investments like Titan (TWI), Denbury (DNR), Chesapeake (CHK) and Transocean (RIG). These stocks benefited enormously from the rebound in commodity prices and accounted for approximately 75% of our overall gain in 2016 (even though they represented only 8% of the portfolio weighting to start the year). We also benefited from broad gains throughout the rest of the portfolio as 15 of 21 positions generated positive results.
Partially offsetting these gains, were losses in two long-tenured positions in the portfolio: Corrections Corp. (CXW) and Calpine (CPN). Corrections Corp. suffered from a combination of increasing political pressure and an announcement by the Justice Department to eventually cease use of private prisons. We viewed these actions as seminal changes in the underlying investment thesis and sold the position (even though the stock rallied significantly after the election). Calpine, another long-term holding, endured weak wholesale power prices throughout the year caused by low natural gas prices, soft generation demand and increasing renewable supply. Nevertheless, we believe these trends will ultimately reverse and the future will look much better for the company than it does today.
Below you can see a chart of the top five winners and losers during the year:
| Top 5 | Bottom 5 | |||
| Name | YTD Price Change | Name | YTD Price Change | |
| Titan International | 164.7% | Corrections Corp. | -31.9% | |
| Denbury Resources | 83.0% | Calpine | -20.4% | |
| Chesapeake Energy | 63.0% | Johnson Controls | -15.1% | |
| Apollo Global Mgm’t | 36.9% | Blackhawk Network | -14.6% | |
| Fidelity National Info. Ser. | 28.7% | Hanesbrands | -8.5% | |
Focusing on High-Quality Businesses
As we mentioned in recent quarterly letters, we made a considerable effort over the past 12 months to improve the underlying quality of the portfolio. We accomplished this by increasing exposure to high-quality businesses with durable franchises and decreasing exposure to more cyclical companies and turnaround situations. Case in point has been the reduced exposure to energy related investments from 25% of the portfolio to 8%. Our goal of shifting the portfolio in favor of high-quality businesses and away from more speculative investments will potentially limit upside returns but will also reduce risk and volatility.
This year alone we added seven new names to the portfolio which fit this description: American Express (AXP), Richemont (CFRUY), Fidelity Information Services (FIS), Hanesbrands (HBI), Johnson Controls (JCI), New Senior (SNR) and Service Master (SERV).
While we are pleased with the progress to date, it should be noted that we were willing to pay a slightly higher valuation for these investments than would typically be the case. This is the harsh reality in a world of ultra-low interest rates and a bull market that is now in its seventh year. Of course, as committed value investors, we still require a margin-of-safety and discount to fair value in order to proceed with an investment. But the discounts are smaller and the bargains are fewer, especially for high-quality companies.
Implied in this shift is a willingness to accept lower future returns in exchange for lower risk and decreased volatility. At this stage in the market cycle, and given the political and economic uncertainties, we think that is the wise choice.
Fixed Income Review
Our underlying fixed income investments advanced 10.9% in 2016 compared to a 2.6% increase in the Barclays Aggregate Bond Index. The significant outperformance was mostly a result of strong gains in our corporate bond holdings which increased 13.7%. At year end we owned 13 individual corporate bond positions yielding between 6 – 9%. These bonds performed particularly well due to improving credit quality and the continued low interest rate environment.
The other segment of our fixed income portfolios – municipal bonds – also performed well during the year with gains of 4.7% compared to 0.2% for the Barclays Muni Bond Index. This triple tax free return benefited from strong gains in our Puerto Rico holdings as well as a relatively short duration portfolio.
If interest rates continue to rise we anticipate adding further to our fixed income holdings and bringing our cash balances back down to the normal historical range. The approximate 120 basis point increase in the 10-year Treasury over the past six months reinforces the patient approach we have taken over the past several years.
Real Estate & Private Equity Review
As we discussed in great detail in last quarter’s letter, we continue to actively pursue investment opportunities in both real estate and private equity. Although we have yet to consummate a transaction, our pipeline is full and we are currently working on several attractive opportunities. As a reminder, we engage in the same rigorous in depth research process for these investments as we do for our publicly traded equity and fixed income investments. While the timing is always uncertain, we are optimistic that several of these deals will close soon. Stay tuned.
The New Abnormal
Speaking of uncertainties, the recent elections in the U.S., Britain, and Italy should, if nothing else, reinforce the notion that the future is always more uncertain than most people anticipate. Nassim Taleb, the bestselling author of The Black Swan, is fond of saying “the world we live in is vastly different from the world we think we live in.”
With that understanding front of mind, it would be wise to remain skeptical of the “expert” predictions for a Trump presidency. Conventional wisdom is that the new administration will focus on economic policies like significant tax reform, decreased regulations, and more protectionist trade policies. Yet, the size, scope, and timing of these initiatives are unknown and the ultimate impact is very difficult to predict.
Fortunately for us, our investment success does not require making these impossible forecasts. Because of our long-term investment horizon we can focus our efforts primarily on the underlying fundamentals of the individual investments we make. Success or failure will be determined by how well we can analyze these fundamentals and the associated risks. Of course, in the short-term anything is possible, but over a long period-of-time these investments will prosper or fail based on their own merits.
As always please feel free to contact us with any questions or comments.